Streetwise Professor

Russia’s economy has been stagnating, and may in fact be in recession.  The Putin Purgatory is reality.

Putin, like most authoritarians, craves stability over everything.  That measures intended to achieve stability usually result in stagnation, “leaders” like Putin consider a price worth paying.

Economic dynamism is inherently dangerous to authoritarians.  It creates new sources of wealth that can be the foundation for alternative sources of power.  It undermines the wealth and power of regime loyalists.  It is harder to orchestrate and control a changing, dynamic economy than a plodding, predictable and sclerotic one.

Add to that the fact that an important part of the Russian economic system, and a main source of income to “law enforcement” and security forces, is shaking down small businesses and entrepreneurs, and it would be a miracle if the economy was anything but sclerotic.   The burst of growth in the mid-00s was the result of a rebound from the catastrophe of the late-90s, the spike in oil prices, and the exploitation of the capital accumulated during the Soviet years.  It was not the harbinger of a transition to sustained, dynamic growth.

I continue to chuckle at the memory of those who, in the aftermath of Putin’s election, opined that he would have to reform the economy in order to ensure growth.  What were these people thinking?

This Pavel Baev article in Eurasia Daily Monitor sums it up fairly well:

This economic weakness shapes the deepest context of the Russian-US counter-reset as Putin suspects that the outflow of investment capital, which determines the onset of stagnation, is orchestrated by his Western enemies.

As these destabilizing developments and misguided responses keep piling up, the space for engaging Putin in meaningful international initiatives that promise no instant gratification is fast contracting. He assumes that every project aimed at advancing Russia’s modernization or increasing its openness to global flows of innovations and information is undermining his grasp on power in the political system where normal evolution is blocked and change might happen only through a coup.

Yes.  The more open Russia is, the less control Putin can exercise.  The more likely it is that dangerous ideas will enter Russia. Add to this paranoia the fact that aging men invariably favor stability over dynamism, and all the ingredients for purgatory are there.

I just read Haim Bodek’s “The Problem of HFT.”  It reinforced my belief in what I’d long concluded, namely, that the problematic aspects of HFT result from the decision of the SEC to create a Simulacrum Limit Order Book-a SLOB-rather than a true Central Limit Order Book-a CLOB-when it promulgated RegNMS.  As I noted at the time, the SEC chose an “information and linkages” approach to create a National Market System that consisted of interconnected competing exchanges, rather than to create a single CLOB.  In achieving competition, it was hugely successful.  Whereas NYSE dominated trading in its listings pre-RegNMS (with a market share in the low-to-mid 80s), now executions are divided rather equally among a handful of exchanges.  There are few rents in securities execution in the US anymore, in contrast to the old floor days.  NYSE’s equity business contributed relatively little to the price paid by ICE for NYSEuronextLiffe.

Part of the decision to  was political economy: politically, the SEC couldn’t have realistically favored one venue, or displaced existing exchanges by creating a new national CLOB.  Part of this decision was predicated on a defensible and understandable desire to encourage competition in securities trading, in fees, rules, liquidity, and technology.  However, the SEC didn’t anticipate how the market structure would evolve, and in particular, how HFT would transform securities trading.  I can’t say that anybody did.  I certainly didn’t.  I thought that automated trading would link markets, but I didn’t see it playing out like it did.

I call what the SEC wrought a “simulacrum” order book because although it incorporates some aspects of a central limit order book, specifically price priority across exchanges for the top of book, it lacks several crucial features of a true CLOB.  Price priority is for top of book only.  Time priority (or other secondary priorities) are not enforced across trading venues.  Markets can cross or lock-which can’t happen in a CLOB, where locked or crossed orders execute automatically.  Moreover, latencies, particularly in the public feed of the NBBO create behaviors and incentives that diverge from a CLOB.

Because it links multiple execution venues, the SLOB has many seams.  And one thing we know is that traders traders look for and exploit seams like Tom Brady looks for and exploits the seams in a zone defense.  Bodek’s little collection of essays goes into considerable detail on how traders have worked the seams, and how their methods have changes in the last 6 years.

The most critical seam in the SLOB, in Bodek’s accounting, is the rule on locked and crossed markets.  The SEC rules state that an order on exchange A that locks or crosses an order on exchange B cannot be displayed.  This complicated the task of quoting aggressively: an HFT that submitted an order that locked or crossed a market would not be able to establish position at the head of the queue.  To address this, traders first used spam and cancel: repeatedly sending orders that were canceled if they locked or crossed, but which would go to the front of the queue as soon as the quote in the away market changed.  Exchanges had implemented algorithms that re-priced orders that locked or crossed away markets, and put them at the end of the price queue.  HFTs circumvented this using hidden order types that were not displayed if they locked or crossed, but which were displayed-and crucially went to the head of the queue at the new price-the instant their price would no longer lock or cross an away market.  HFTs also used sweep orders to establish priority.

The common features behind all of the things Bodek criticizes are that (a) they are all intended to establish priority, and facilitate aggressive quoting, and (b) they can happen in a SLOB, but not a CLOB.  They give an advantage to HFT firms that invest in the technology and in understanding the order types, to the detriment of those who don’t (including many institutional investors): this is Bodek’s main beef.  They are an artifact of the prohibition on locks and crosses, and this can only occur in a fragmented market structure that precludes locks and crosses.  If locking and crossing orders were matched against one another and executed, as would happen in a true CLOB, much of the gaming of order types Bodek laments would go away: I suspect, however, that latencies across a system of linked exchanges would make this impractical.

This relates to, and complicates, points I made in my writing on exchange competition in the late-90s and early-00s.  Competition between privately operating CLOBs with no obligation to route orders to markets displaying better prices is likely to result in the survival of a single dominant platform that exercises market power.  This is arguably the case in futures markets.  A CLOB utility that is regulated to mitigate this market power problem raises myriad difficulties.  Who will operate it?  How will rates be regulated?  How will access be regulated?  (One way to exercise market power is to limit access to the CLOB.)  How will the CLOB utility be governed?  How is capture (by major intermediaries, for instance) to be avoided?  How can the CLOB be incentivized to be technologically innovative, rather than a lazy monopolist (especially since some technological changes may be very disruptive to the business models of important market participants)?

Socializing order flows by requiring exchanges to route orders to other markets displaying better prices encourages competition, and seemingly avoids the problems posed by private CLOBs and utility CLOBs, but raises its own difficulties.  Indeed, these are the problems that we are experiencing today, and which Bodek identifies.  This raises the question: can we clean up SLOBs so they are more truly CLOB-like, while retaining interexchange competition that mitigates market power problems?  The answer to this question has both technological and political components.   A system of linked exchanges necessarily has seams and latencies and inter-market coordination issues absent in a true CLOB, and these are vulnerable to gaming and breakdown, and even during normal operation represent a more complicated and error-prone way of allowing all orders to interact with one another than a true CLOB.  The political components arise from the fact that interested parties, most notably exchanges, major sell side intermediaries, and big buy side institutions, will strive to shape the system’s design and rules to advance their interests.

The trade off is therefore pretty stark: it’s a pick-your-poison kind of thing.  Don’t socialize order flow and live with market power, or socialize order flow to facilitate competition, and grapple with the technological challenges of creating a virtual CLOB, and fighting the never ending battle against attempts to exploit the seams.  I don’t claim to know the right choice, but I think that framing the issues in this way will permit far more constructive debate than the one currently ongoing.  This debate has become Manichean: good vs. evil: black hats vs. white hats.  It is oddly ahistorical, in its failure to recognize the problems with the previous system.

Perfect is not an option here.  Which is why debates over securities and derivatives market structure have been raging for as long as securities and futures have been traded.  The debate would be more productive-less sterile-if the choices were framed more clearly.  I’ll keep trying.

Richard Epstein has written about “government by waiver,” and its pernicious effects.  We’ve had numerous examples of late, from the Obamacare waivers, to the suspension of the employer mandate, to yesterday’s decision to exempt Congressional staff from Obamacare.  Yesterday also brought news of another administrative version of Emily Litella’s (and Nirvana’s!) “Nevermind”: the EPA is easing renewable fuel standards that had wreaked havoc in the gasoline market, and driven prices for Renewable Information Numbers “RINs” from pennies to nearly a dollar per gallon:

The Environmental Protection Agency, which administers the mandate, has said it will reduce total required volumes in its forthcoming proposal for 2014. It also extended the compliance deadline for 2013 by four months to June 30 of next year.

We’ve seen this movie before.  Congress passes expansive feel-good legislation that is at complete odds with economic reality.  Those who have to deal with economic reality importune the executive branch and administrative agencies for relief, and some sort of relief is granted.  (As another example, CFTC has also granted various forms of relief for some of the Frankendodd craziness.)

In the case of RINs, Congress demanded that refiners utilize far more renewable fuels (such as ethanol) than is feasible, given the installed base of auto engines which can only utilize 10 percent ethanol fuels.  Refiners could purchase unused renewable fuel credits (RINs) accumulated in past years when renewables usage exceed the then-lower mandated levels, but these are running out, and the renewable requirement was increasing even more for 2014.  Thus, the price of RINs had rocketed higher and there was risk that there wouldn’t be near enough for 2014.  The regulations also favored exports of gasoline because exported gas does not count towards renewables requirements.

So EPA stepped in and gave relief.  Because Congress couldn’t be bothered to worry its little head about minor details like the ability of the engines in hundreds of millions of autos to use the amount of ethanol it, in its infinite wisdom, decreed.

This is perverse in many ways.  It encourages rent seeking, at times to the point of corruption, or at least highly dubious political favoritism and dealing.  It empowers unelected bureaucrats who are difficult enough to hold accountable as it is, and who are often pursuing ideological agendas, and who can use their leverage to advance those agendas.  It allows Congress to avoid being held responsible for, let alone accountable for, its careless legislating: why take care in attempting to anticipate perverse effects when there’s someone there to clean up your mess?  It creates substantial uncertainty that discourages investment and hiring.  We end up with a thicket of ad hoc responses to legislative pipe dreams that lead to further problems that lead to more ad hoc responses and on and on.

In some respects, the RIN fiasco is the least of the renewable mandate’s sins.  Ethanol is a disaster on many dimensions, economic and environmental.  These problems are bad enough, but the EPA’s action is emblematic of a broader problem with the mega-legislation of the Bush-Obama years.  The legislation is unworkable, and compels delegation of considerable discretion to largely unaccountable administrators.  It undermines the rule of law and makes the US more like a natural state-or banana republic.

It’s Friday, and so a funny is called for, and this article on Rosneft in Eurasia Review (“News and Analysis”!) fits the bill.  The Tiger Beat tone of Kerim Has’s article has to be read to be believed.  Yes, he does acknowledge Rosneft’s dependence on the Russian state, but he still gives the impression that Rosneft is a real commercial venture.

Rather, it is a corporate Frankenstein, stitched together from stolen body parts and vivified by jolts of state power.  Here’s how the article treats the most important such part:

At this time, Yukos, then the largest petroleum company in Russia was having its assets transferred to Rosneft, a process which continued until 2007. And Sechin was one of the main actors in the Kremlin’s energy policy in this process

“Having its assets transferred.”  How’s that for a euphemism?: that’s not funny, it’s sick.  Note the passive voice.  Just who did the transferring?  How did that “transfer” take place?  And-most importantly-was the transfer consensual?

My neighbor had his assets transferred once.  It was called a B&E by the police.

I actually agree with one part of the article:

To sum up, energy politics and “pipeline diplomacy” which aimed Russia to regain its “global power” position in international arena seem to keep their vital importance still for long as key instruments of Kremlin’s foreign policy. During 2000’s, Putin’s this state-centred energy strategy allowed Gazprom to become a giant company in both the domestic and international natural gas markets. And now, it is being reapplied to clinch Rosneft’s dominance over the petroleum production and exporting sector. Rosneft is taking on important duties for the Kremlin, and it looks as if it will be one of the vital pillars of Russia’s transformation into an energy superpower.

There is no doubt that Putin will succeed with Rosneft just like he “succeeded” with Gazprom.  He will succeed in creating a corrupt, bloated, inefficient, wasteful firm that is indeed a giant.  But the most gigantic thing about it will be its capacity for value destruction and peculation.  Indeed, he’s almost there.

It’s all so confusing.  During the last spasm of Congressional criticism of the “financialization” of commodity trading, mainly during the Frankendodd “debates” over position limits, the target of criticism was evil speculators who trade commodities for purely financial reasons, and who have no involvement in the physical markets.

In the latest incarnation, the alleged problem is that financial firms that trade commodities paper do have physical commodity operations:

What concerns Brown and Senator Jeff Merkley, Democrat-Oregon, is that banks have numerous physical commodity holdings as well as the means to deliver those commodities, including oil tankers, transmission rights and pipelines, while they at the same time trade on energy prices in futures and swaps markets.

Big banks can buy “vast quantities” of commodities and pipelines, tankers and warehouses, said Merkley. This gives them “a huge amount of market information that’s very advantageous in trading” and gives them a “thumb on the scale in the terms of supply and demand and being able to have some influence over the price,” he said.

“If you’re simultaneously allowed to bet on the price and you’re allowed to have your thumb on the scale in reflecting the price it’s a huge conflict of interest,” he said.

“Financial institutions own fleets of oil tankers and can withhold delivery, while wagering on the price of oil or they can speculate on the price of energy while controlling supply,” Brown said.

This, the senators said, is a clear conflict of interest that is driving up commodity prices.

Make up your minds, people (which generously assumes you have them).  Is the combination of physical and financial trading a good thing, or a bad thing?

As someone who has arguably written more about commodity market manipulation than anyone alive, I can say definitively that the most costly manipulative strategies-corners and squeezes-involve trading of “paper” (e.g., futures contracts) and the physical commodity.  These strategies involve either taking excessive deliveries, or buying in excessive quantities in the physical market.  Engaging in a market power manipulation requires some involvement in the physical market.

Historically, many of the biggest manipulations have been undertaken by hedgers.

And that’s the key point that escapes the Washington hand-wringers.  On one of their wringing hands, they lament the involvement of non-hedgers in markets (let’s leave aside how you can have hedgers without speculators to take the other side of trades).  On the other, they bemoan the fact that those involved in both the physical and financial commodity markets-who are often hedgers-can sometimes exploit market power to enhance profits.  But if you believe that a primary function of commodity derivatives markets is to facilitate risk management by those involved in the producing, marketing, storing, and processing of commodities, you have to permit the physical traders to trade derivatives.

One of the consequences of that is that there will be manipulations by physical players.  But severing physical and financial trading in order to prevent manipulation, which is what Brown and Merkley and others are suggesting, is crack-brained.  It throws the hedging baby out with the manipulative bath.

And it is particularly crack-brained to focus on just one category of market participants, like banks.  The potential for manipulation exists due to frictions in the physical market, and the ability of some market participants to trade both derivatives and the underlying commodities.  Someone will step into the banks’ role if they are precluded from the market, and the potential for manipulation will remain.  Taken to its logical conclusion, the Brown-Merkley “conflict of interest” standard would preclude any entity-not just banks-from trading both commodity derivatives and the underlying physicals.

So what’s the best way to attack manipulation?  Not by destroying the ability of the markets to perform their vital risk transfer function.  Instead, as I’ve argued for going on 20 years, the best way is to impose penalties after the fact for manipulative conduct.  Thus, at least conceptually, I support FERC and CFTC enforcement efforts.  The problem is that practically their efforts are often misdirected and intellectually confused.

Congress should economize on its limited comprehension of these issues by focusing on the key problems, rather than throw around vapid phrases like “conflict of interest” and recommend policies that undermine the ability of financial and physical commodity markets to function effectively.  Better anti-manipulation laws predicated on a clear understanding of how manipulation works would be the place to start.  And no, this does not involve the Xeroxing of 10(b)(5) of the Securities and Exchange Acts and inserting it into commodity trading laws, which has been Congress’s default response for about a decade.  There is a complete mis-match between the fraud-based thrust of 10(b)(5) and the market power problems that sometimes arise in commodity markets.  I’ve made recommendations over the years on the right regulatory/legislative approach that would target market power problems more precisely.  This approach would permit the markets to exploit the synergies between paper and physical trading while at the same time improving the efficiency of these markets.

But instead, we get Congressional schizophrenia and meat cleaver approaches that would, if taken to their logical conclusion, destroy the markets in order to save them.

A further thought.  Those who have the ability to trade the physical, and who have extensive information and developed logistical capabilities are usually the best positioned to break corners, and to mitigate the frictions that make corners possible.  They also have the strongest incentive when they have a derivatives position that would be hurt by a manipulation.

I’ll post a link when I have a chance, but P.D. Armor’s breaking of the Leiter wheat corner in 1898 is a great example of this.  There are many others.

The FT raises the alarm that hedging by US oil producers will undermine the shale oil boom:

As the US shale revolution transforms global trade in oil, it is also causing upheaval in the derivatives market – and making life harder for America’s shale producers.

The companies behind rising US crude production are selling more of their output in advance to guarantee revenues. That is putting downward pressure on future oil prices – making it harder for those companies to enter crucial hedging contracts.

. . . .

The principal reason for the downward drift in prices, say analysts and traders, is the hedging activities of shale oil producers themselves. As the volume of production in the hands of independent producers grows – EOG, a bellwether independent oil producer, doubled crude and condensate production between 2010 and 2012 – so does their hedging activity.

Um, no.  This is a classic case of someone confusing correlation for causation.  What’s driving down prices is the rise in output: the rise in output is also leading to more hedging activity. Yes, there will come a point where price comes down to a level that some producers will find it better to keep the oil in the ground.  That’s the market in action.

There’s also this fascinating detail:

“There has always been a mismatch between producers and consumers in the futures market, but the increase in production by independents has made it worse,” says Jonathan Whitehead, global head of commodities markets at Société Générale.

Hmm.  Buys and sells are equal in equilibrium.  So just who balances that mismatch?  Think. Think. Think.

Let me venture a wild guess: Speculators?  So you mean that speculators are needed even more now than ever before?  That without speculators hedging would be even more costly, and that would depress oil production?

Who knew?

No sooner than I had written a post that showed the potential comparative advantage that banks had in dealing in physical commodities did JP Morgan Chase announce that it was throwing in the towel, and exiting the business:

Wall Street’s biggest bank said an “internal review” had concluded it should pursue “strategic alternatives” for its physical commodities operations, which includes assets like its Henry Bath metals warehousing subsidiary and a vast global team trading everything from African crude to Canadian natural gas.

The firm will explore “a sale, spinoff or strategic partnership” for its physical arm, the statement said. It said the bank remained “fully committed” to its traditional financial commodity business, including trading derivatives and its activities in precious metals.

This decision was not the result of any single thing, but the cumulative result of many things.  Greater capital requirements for banks.  The maturation of commodity markets and the resulting flattening out of profits.  The reputational risks of commodities dealing, with multiple regulators on the hunt for manipulation cases, and asking for big dollars to settle them.  And, most recently, the political heat directed at banks’ commodity trading operations.  Morgan’s commodity trading operation was big absolutely, but relatively not as big as Morgan Stanley’s or Goldman’s, and hence more readily expendable.  Morgan decided to get out of the kitchen, rather than stand the heat.  Especially since there is political pressure on all aspects on the banking business, and since navigating the post-Frankendodd, Volcker Rule world will be sufficiently challenging to the core businesses that commodities risks, political and reputational more than financial, just aren’t worth it.

Morgan Stanley has already mooted selling off its commodity arm.  It will be interesting to see what Goldman decides to do, especially in light of the Metro melodrama.  The European banks (notably Deutsche and Barclays) also have some thinking to do.

The exit or downsizing of bank commodity operations will redound to the benefit of the trading houses, and to private equity shops and perhaps hedge funds, including potentially some new entrants.  I doubt it will make the commodities markets more competitive, and indeed, the opposite is more likely to be the case. This turns my minds to thoughts regarding the political economy of the pressure on the banks.  The exit and downsizing also run contrary to the meme that banks have it all their way inside the Beltway.

The banks have done a terrible job of making their case.  Perhaps it would be more accurate to say that they really haven’t made a case at all, likely as a result of hubris.  They know they are doing God’s work (to steal from an old commodities guy, Lloyd Blankfein, who started his career at J Aron), but really need to work on their evangelism.

There is indeed a karmic aspect to this.  Almost instant karma, in fact: following my musing about that by only a few days.  I don’t say that with the least tinge of schadenfreude.  Just stating the obvious.

I wonder what will happen to Blythe Masters, the head of Morgan’s commodity operation.  I know her some.  Most of our interactions were positive, until we butted heads over the report I wrote on commodity trading firms: in fact, she approached me to write the report because she’d liked what I’d written on the blog, and in comments to the CFTC.

I have a distinct recollection of sitting next to her at the JPM commodities conference in October, 2011, and watching the muscles in her jaw bulge as she ground her teeth furiously.  She was obviously very tightly wound.  If she was that intense before a relatively low-key conference presentation, I can only imagine how her jaw is working now.  My guess is that she will stay at Morgan for a decent interval, and then land somewhere else.  Like perhaps a private equity commodity trading shop.

Exit for economic reasons is part of the market process.  Exit driven by political or regulatory pressure is problematic.  Both factors are at work now, but unfortunately political and regulatory issues are predominating.  The result will be less efficient, less competitive commodity markets.  Which is exactly the opposite result that the politicians and regulators baying at banks and nipping at their heels claim to want.  Unintended consequences yet again.

In its 2003 Physical Commodities Trading Order, the Fed permitted bank holding companies (not the depository institutions under the BHC umbrella) to purchase and sell physical commodities because they are “meaningfully connected to a financial activity such that it complements the financial activity.”

I mentioned one example of this the other day in the “Get Physical” post (and don’t worry: I won’t post any Madonna videos!), but want to go  into more detail.  The example is offtake agreements (and relatedly, tolling deals).  In these arrangements, a bank (or other counterparty) agrees to supply inputs (e.g., crude to a refinery, gas to a power plant) and receives delivery of outputs (e.g., gasoline and heating oil, electricity).

Refineries, power plants, and the like typically need to pay for the inputs they process before they receive payment for their outputs.  This creates a need for working capital to finance the timing gap between cash outflows and inflows.

Providing funding for working capital is clearly a traditional banking activity.  One way to do this is for the bank to provide a loan or credit facility, and leave the refiner or power plant to acquire inputs and market outputs, and bear and perhaps manage the price and operational risks associated with those activities.

This exposes the bank providing the funds to risk: adverse movements in prices could put the refiner or generator into financial distress, and perhaps cause a default.  The bank could require the borrower to hedge, but there is a moral hazard: if it doesn’t, or doesn’t do it effectively, the lender bears risk.  The bank can monitor, but this is costly, and often imperfect.

The moral hazard problem can be eliminated by passing the risk on to the lender.  An uptake agreement or tolling deal does this.  These types of deal implicitly provide funding to bride the outflow-inflow gap, and pass the price risks back to the lender.  The lender can manage these risks, and the agency cost in this arrangement is lower: there’s no moral hazard, and no need to monitor.  Thus, bundling price risk management and funding can reduce the cost of funding working capital needs.  This is presumably more valuable for lower credit quality refiners and generators.

There are other potential benefits.  The lender may have a comparative advantage in managing risk due to specialization and expertise in this function: banks and commodity trading firms have a comparative advantage in risk management.  Moreover, they may able to be able to manage risk more cheaply because they run large books: there are economies of scope in risk management.  For instance, a lender doing an uptake deal with a refinery is short crude and long products, but it might have a long crude position based on a trade it executed with producer, and might have a short products position as the result of a swap with an airline or heating oil dealer.  These natural hedges reduce the amount of trading necessary to manage the risks.

Moreover, trading firms specialize in marketing and logistics, and there are scale economies and scope economies in these activities.  It may be cheaper for a big trading shop to provide marketing and logistical services, thereby eliminating the need for the refiner or the power plant to pay the overhead associated with such activities.

Thus, there are strong complementarities that make it beneficial to bundle financing, logistical, and marketing activities for some firms that process commodities.  Who should provide these bundles?  Banks have comparative advantages in funding and risk management, and can develop and staff physical trading operations.  Commodity trading firms are typically more expensive suppliers of financing, but they have strong competencies in marketing and logistics.  So both banks and commodity traders are reasonable suppliers of the bundled services, and thus reasonable counterparties in offtake and tolling deals.

What would be the effect of banning some market participants, like banks, from these activities?  Econ 101 gives the answer.  If these entities currently supply the bundled service-as is the case today-elminating them from the market will shift up the supply curve for this service, and in equilibrium it will be more costly.  Meaning that refiners and power plants will incur higher costs that will be passed upstream (lower prices for inputs) and downstream (higher prices for outputs).  To the extent that restricting participation gives (or enhances) the market power of those who remain in the market, these effects will be exacerbated.

What if some market participants-such as banks-get a subsidy of some sort that allows them to offer these services below cost? That is a source of inefficiency, to be sure: too much of the service is provided in equilibrium, and the beneficiaries of the subsidy have an excessively large market share.  But it does not follow that banning the subsidized from the market is the right policy response.  It’s usually better to eliminate the subsidy, especially in the case of something like a too big to fail subsidy, which has pervasive and perverse effects in all the markets in which the subsidized banks operate.

Evaluating the regulation of bank participation in any market, including the commodity markets, should proceed along similar lines.  The concept of complementarity is the right way to consider these issues, and that principle can be analyzed in particular instances using basic economic analysis.  The survival principle also suggests that if a firm gets market share in a particular business, it is because it is providing that service at lower cost, or delivering higher quality.  If the lower cost is an artifact of some sort of subsidy, eliminate the subsidy, especially when it is a pervasive on that cuts across myriad lines of business.  Populist venting about banks, especially venting based on some cramped understanding of what banking is and predicated on some belief that the involvement of financial institutions in commodity markets is somehow unnatural, is counterproductive.  It is also likely really a mask for some political economy agenda, an effort to benefit one group of firms by handicapping-or eliminating-others.

Earlier in the year I wrote about the obscure, but very important, regulation of futures commissions merchants that essentially requires them to hold enough of their own money to cover shortfalls in customer margin accounts.  This “residual interest” rule has caused a wholesale freakout among FCMs and market participants, and for good reason, as I pointed out in that post.  The rule would not have prevented an MF Global or Peregrine situation-those involved fraud and/or numerous rule violations.  Moreover, the rule puts further strains on the funding liquidity of the futures markets.  There are already new strains aplenty, and liquidity shortages are a major source of systemic risk.  A rule ostensibly designed to protects customers puts the entire system at greater risk.

The near universal opposition of the industry is leaving the CFTC unmoved.  But the CFTC’s response is purely legalistic, and does not even attempt to address the fundamental economic issues:

But on Thursday, at an open meeting of the Agricultural Advisory Committee to the CFTC, regulators were unmoved by the criticism.

The proposed rules, said Ananda Radhakrishnan, director of the CFTC’s division of clearing and risk, merely clarify what the law already says: funds from one customer must not be used to pay for the position or deficit of another customer

“Nobody’s been able to make the argument, with all due respect, that what we are suggesting is not what the law says it is,” Radhakrishnan said. “The arguments we’ve heard … (are) that it’s going to be expensive, the earth is going to fall and so on and so forth. But nobody has done, to my view, a legal analysis saying, ‘your analysis is wrong.'”

Translation: “The law may well be an ass, but we’re rolling with it.”

I have some sympathy, because Congress has handed the CFTC many legislative directives that are at odds with economic common sense, and which are actually contrary to the purposes of the legislation (notably, the reduction of systemic risk).  But where there’s a will, there’s a way.  I get the sense that the CFTC is just hiding behind the legalisms in order to force through a proposal that it-and most likely Gensler-wants.  If it had the will, it could likely find a way to adhere to the law as written but substantially mitigate the negative impacts of the regulation on liquidity, costs, and systemic risk.  The failure to do so, and the appeal to the “Congress made me do it” defense (seen so clearly in the position limits regulation, and repeated in its appeal briefs) strongly suggests that the CFTC doesn’t have a strong economic justification for its regulation, can’t rebut the arguments of the critics, and is playing legal rope-a-dope in order to force through one of Gensler’s (and perhaps the staff’s) bright ideas/obsessions.

In 2009 I called China the “Michael Jackson economy,” meaning that it was kept going by artificial stimulants, but that inevitably their cumulative effects would cause  serious, and perhaps fatal problems.  They mask the effect of the underlying ailment, and have severe side effects.   China responded to the 2008 financial crisis by engaging in massive stimulus, and has inflated credit bubbles whenever growth stuttered in the past several years.  Moreover, allocation of credit and investment in the economy is subject to substantial direct and indirect government control.  Local governments invest massive amounts in infrastructure and housing projects, and the banking system is tilted to direct credit to large state enterprises that invest primarily in heavy industry-steel manufacture and shipbuilding, for instance.

This “investment” can prop up GDP statistics, but they are recorded at cost, not value.  (I recommend this David Henderson piece about the perversity of GDP fetishism, and how GDP can grossly mis-measure well-being.)

If the investments are ill-conceived, they will not pay for themselves in the future, and economic output and consumption will suffer.  And investments guided primarily by the visible hand in an authoritarian state are almost certainly ill-conceived.  They are driven by considerations like political connections, prestige, and the imperative to maintain employment in existing enterprises and regions to buy labor-and political-peace.  This latter effect is particularly deleterious, as it means that rather than there being a natural corrective mechanism for past mistakes, mistakes tend to be self-perpetuating.

The Wall Street Journal has a fascinating article about one major malinvestment that fits this story almost perfectly.  Yes, it is likely an extreme case, but there are enough similar stories to suggest that that the malivinestment problem in China is severe.  Moreover, the bloated fraction of investment to GDP, and the falling delta between changes in credit and changes in income provide some quantitative support for these anecdotes.  Add in the dodginess of Chinese economic data, and there is serious reason to believe that China is heading for a very rocky period.  When the interactions with the financial system are considered, the prospects look even more dire: when the investments don’t generate sufficient return to pay back the loans, realistic outcomes range from a Japan-like zombie-fication of the banks to a full-blown financial crisis.

China’s new premier is promising 7+ percent GDP growth.  That could be the problem: the only way to get it is to double down on the artificial stimulants, thereby exacerbating the malinvestment problem.  Living with lower GDP growth, and permitting Chinese businesses and individuals to reallocate resources to those that generate value rather than statistics, would be far preferable in the short, medium, and especially long run.

A major adjustment is needed, but I would have little confidence in the Party and the system that created the mess in the first place to manage this adjustment effectively or efficiently.  The political economy suggests that incumbent industries, firms, and interests, all of which have strong political influence, will disproportionately influence government economic policy.  This impedes adjustment, and substantially increases the odds of zombie-fication, of the financial system and entire industries.  China could use some creative destruction, but I do not believe this is politically feasible.

China is one of those few matters on which Krugman and I agree.  Krugman mentions that this could be bad for commodity prices, and that would definitely be true if China goes cold turkey and stops trying to perpetuate its old growth model.  That will lead to a substantial decline in the demand for commodities such as industrial metals, iron ore, coal, and oil.  But if the political economy story is correct, it will attempt to support the existing commodity-intensive structure of production and delay the adjustment process.  In the event, commodity prices will likely fall, because a reprise of 2009’s extreme dosage of stimulants is likely infeasible.  But government attempts to cushion the adjustment process will cushion the impact on commodity prices too.

But it is true that the course of commodity prices will depend crucially on how the Chinese government handles the painful withdrawal from its past stimulus binge.  Cold turkey would be very bearish (how’s that for a mixed metaphor!?!) Hair of the dog far less so.  This implies that a crucial fundamental in commodity markets in coming months and even years, and perhaps the crucial fundamental, will be Chinese politics.